California Estate Planning Attorney

Portability of the Estate Tax Exemption

Jan 15, 2022 | Blog, Estate Planning

The legacy you leave your loved ones and cherished causes includes the values you instill in them, directives for the future, personal possessions, financial assets, and real estate. Considering how you will pass on these pieces of your legacy is an essential part of developing your estate plan. You want your heirs to receive everything you want to leave for them, and that is why it’s helpful to understand what it will cost to transfer your assets to your beneficiaries.

What Are Estate Taxes and Who Pays Them?

When you die, your assets — including cash, real estate, stock, and other assets with a monetary value — are subject to tax. Depending on where you live, you may owe only federal estate taxes or a combination of federal and state estate taxes. Thirty-eight states (including California) do not have an estate tax.

The Internal Revenue Service calculates your estate tax using a formula that combines a base tax and your marginal rate. Base taxes range from $0 to $345,800, and the marginal tax rate starts at 18% and ends at 40%. In the United States, only the wealthiest families pay estate taxes because the government levies the tax only on a portion of the estate’s value.

An estate tax is not the same as an inheritance tax. Two key differences between them are who levies the tax and who pays it. The deceased person’s estate pays the estate tax. The deceased person’s heirs pay the inheritance tax. In the United States, there is a federal estate tax but no federal inheritance tax.

What You Need to Know About Estate Tax Exemption

This doesn’t mean your estate automatically pays taxes after you die. The government allows an estate tax exemption — a portion of your assets that can transfer to your beneficiaries tax-free. In 2022, the estate tax exemption is $12.06 million for individuals who are US citizens and $24.12 million for married couples who are US citizens. Different estate tax rules apply to non-US citizens and non-resident aliens who own assets in the United States, but we are not discussing those issues here.

The estate tax exemption dates back to the Revenue Act of 1916, when the federal government started taxing estates valued at over $50,000. This exemption stayed in place for ten years, when the amount increased to $100,000 before bottoming out at $40,000. Since then, the value of the estate tax exemption has grown each year.

Everyone is entitled to an estate tax exemption. Here’s how it works. Say, for example, you are single and leave behind an estate worth $10 million. Since your estate falls below the exemption amount, your estate does not have to pay federal taxes on your assets. If your estate is worth $20 million, your estate pays federal taxes only on the portion of the estate that exceeds the exemption limit.

Remember that every person is entitled to an estate tax exemption. If you are married, you also have the option to transfer all or part of your estate tax exemption to your surviving spouse. This provision is called portability, and it can be a valuable tool for married couples to consider as they develop their estate plans.

How Portability Works

Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 introduced portability to the estate tax laws. Portability became permanent as part of the American Taxpayer Relief Act of 2012, which took away its sunset provision. In doing so, it would now take an Act of Congress to eliminate.

It is important to note that portability only applies to married couples. They are allowed to transfer the unused portion of the estate tax exemption to their spouse. The surviving spouse then enjoys the combined exemption, adjusted for inflation. Having portability can make a significant difference in the surviving spouse’s estate.

For example, say you and your spouse have a net worth of $20 million with jointly owned assets. If your spouse dies, their assets total $10 million (one-half of the combined total). Since this amount falls short of the estate tax exemption, your spouse does not have to use it. The assets automatically transfer to you, and you do not have to pay federal estate taxes.

Portability comes into play later when it is time for your estate to transfer to your beneficiaries. Say your assets do not appreciate and are still worth $20 million when you die. If you were able to claim your spouse’s unused estate tax exemption, your beneficiaries would not pay taxes on your estate because it is still below the threshold of $24.12 million.

Without portability, they will pay taxes on the difference between the value of your estate and the current estate tax exemption. In this example, that is nearly $8 million. At a tax rate of 40%, they have to pay more than $3 million in taxes to the government. Portability eliminates that tax bill.

Portability Isn’t Automatically Conferred

Being married does not automatically allow you to claim your deceased spouse’s exemption. However, the IRS has steps for you to follow. This starts with filing an estate tax return with the Internal Revenue Service within nine months of your spouse’s death. Extensions for six months are available in some cases as long as the estate meets the required threshold.

You also do not automatically get all of your deceased spouse’s estate tax exemption. You can claim what is left of their exemption. If your spouse made a gift during their lifetime, the gift tax exemption lowers the exemption available to you. For example, if your spouse’s gift was $5 million, the remaining exemption is just shy of $4 million.

Limitations of Portability

Portability is beneficial, but it does have some limitations. Couples should be aware of them and keep them in mind as they plan their estates. It is important to understand how portability works and how the laws apply in their unique situation. In some cases, other options like incorporating a family trust may be appropriate.

Appreciation

Your estate tax exemption appreciates with time, but your deceased spouse’s unused estate tax exemption does not. Say, for example, that the exemption is set at $15 million at the time of your death, but your spouse died when the rate was still $12.06 million. Your combined exemption is $27.06 million. If the value of your estate is greater than your combined exemption, your beneficiaries will pay taxes on the remaining portion.

Asset Protection

If you choose to transfer your assets directly to your beneficiaries, you may be giving up some valuable protections available through a family trust.

Some people choose to place their assets in an irrevocable trust to protect them from creditors or from becoming part of divorce proceedings. A professional estate planner who understands your situation can help you choose the right options for you.

Citizenship Limitations

If your spouse was not a U.S. citizen at the time of death, you may not be able to claim their unused estate tax exemption because it does not extend to all non-citizen. At the same time, your estate tax exemption may be considerably lower if you are not a citizen when your spouse dies. If you become a citizen within nine months after their death, this restriction no longer applies.

Remarriage Restrictions

You can claim the estate tax exemption from your “last” deceased spouse only. If you remarry, you give up portability with the first spouse and have it with your current spouse, which may not be significant if the maximum exemption amount is the same for everyone. It does, though, make it impossible for someone to engage in serial marriages just to accumulate estate tax exemptions.

Statute of Limitations

If tax portability is elected, the statute of limitations on the decedent’s spouse’s estate can remain open until the law expires on the surviving spouse’s estate, which is generally 9 months after the decedent’s death, but in certain instances, can be as long as 15 months if an extension is available.

Note if the spouse elects to use DSUE (Deceased Spouse’s Unused Exemption), it is advised to do so promptly. However, when making this election, the time limit on when the IRS can review the return to challenge the estate is extended until the statute of limitations expires on the survivor’s estate, which is generally 3 years after the estate tax return is filed.

How to Seek Estate Planning Advice

Having access to your spouse’s estate tax exemption can greatly affect the legacy you leave your loved ones. This is especially true if you don’t have a solid estate plan in place.

Whether you have ignored planning your estate or have not looked at your plan in years, it is never too late to think about what will happen to your assets down the road.

Estate tax planning is not a one-size-fits-all or a one-and-done process. What provides the greatest benefit for someone else may not be useful for your situation. Furthermore, changes to laws can have significant effects on what happens to your estate and the steps you should take to protect it.

An estate planning professional can help you develop a plan that ensures your assets go to the people and organizations you choose, set up trusts to protect your assets, make arrangements to care for your children or business interests, and much more. Call today to schedule a consultation.